Be That Annoying Kid

Why?  It’s a very important question and one that isn’t asked enough. Investors need to be like that annoying kid that just keeps bugging everyone who’s willing to listen.  Why is the sky blue?  Why can’t we see the wind?  Why does the moon keep changing shape?

But many Investors don’t ask questions that are two and three layers deep.  Worse, some Investors are willing to accept the age old answer “just because” or are willing to trust that the company they’re evaluating has the “details” under control.

Example conversation:

Founder: We have an extra layer of protection in our student loan portfolio because 90% of all loans are co-signed.

First why: Why does co-signing help?

Founder: Because there’s someone with solid credit that’s responsible for the loan if the student isn’t able or willing to pay.

Second why: Why would they co-sign for the student?

Founder: Because they know him/her and believe in his/her character

Third why: Why does belief matter in a credit risk decision?  Do you have proof?  And aren’t these loans going to students that haven’t yet had much of a chance to prove their ability to handle financial matters on their own?  Aren’t they unemployed and living off the loans or other money from relatives?

Founder: Sure.  But we also feel good because there’s a credit worthy person on the hook in case the student isn’t able to pay.

Fourth why: Why are you comfortable that the co-signer will be able and willing to pay if the student ends up defaulting? 

Founder: Because they have good credit scores and have paid all their other bills in the past.

Fifth why: Why do you believe that using a generic credit score from the bureau correlates with a co-signer’s willingness to pay?  What checks have you put in place to make sure that the co-signer understands their obligation and is mentally willing and financially able to pay for the loan in case of default?

And so on….

It ends up in this case the “whys” matter because not all co-signers are equal and not all co-signers actually intend on paying in case of default.  Some co-signers wouldn’t have the ability to pay even though basic models would say they do (i.e. – Many grandparents on fixed income have good FICO scores and low DTIs but are living paycheck to paycheck).  Other co-signers haven’t internalized the obligation (i.e. – Uncle who fundamentally believes that his niece/nephew will be able to support the loan and is co-signing because the parents are maxed out).  And some co-signers are as good as gold (i.e. – Both parents co-sign and know that there’s a good chance they’ll have to step in to help because their son/daughter is studying art history).  The FICOs and incomes and DTIs of these various co-signers might be very similar, but without building a policy based on first principles this would never be discovered.

(And in case you’re intellectually curious, there are actual cases where the presence of a co-signer can be a signal that a loan will perform worse than if the co-signer didn’t exist….)

So…be that annoying kid and keep asking questions until you fundamentally understand what the heck is going on!  Q.E.D.

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6 thoughts on “Be That Annoying Kid

  1. Good article Frank. Rich Uncle is no better than the poor dad in many cases. Correlation analysis suggests that weakest link the chain predicts risk better. Student’s credit score or co-signer’s credit score, which ever is lower, is more predictive. Analysis should always delve into 3 or 4 levels to understand the true underlying pattern in credit risk.

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    • You can…but there’s a lot of “signal” embedded in who the co-signers are. Just adding more doesn’t necessarily reduce the risk of the loan and there are situations where “shopping for co-signers” is a major negative flag. I’ve seen it, I’ve had to deal with it, I learned from it, now I look out for it. QED.

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  2. What type of policy can you put in place to address this risk? Is it as simple as co-signer has to be a relative + have 700 FICO (or more) and a certain cash flow?

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    • It’s not a simple issue to solve. A combination of good policy plus good disclosures about the repayment obligation plus operational steps that insist on talking to marginal co-signers is about as good as you can do. The key is not to assume that the mere presence of a co-signer reduces the risk of the loan….it just isn’t true.

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